Within the next 10 years, $895 billion is expected to change hands through intergenerational wealth transfers.1
When you’re working with clients on intergenerational wealth transfers, the goal is to ensure their money goes to the people they care about, in the most efficient way possible.
One hurdle in making this happen comes in the form of taxes.
Income tax laws state that property must be disposed of at fair market value immediately before death (with a few exceptions, such as a rollover to a spouse). The estate is generally responsible for covering the applicable taxes, which can take a chunk out of what your client hopes to pass down.
What are the options when you’re seeking to preserve your client’s estate for the next generation?
Minimize taxes to maximize estates
Éric La Charité, director of advanced planning with Sun Life Financial, says permanent life insurance is a great option.
“Tax legislation lets you transfer the interest in a life insurance contract without paying tax, subject to certain conditions,” he says. “For affluent clients it’s a really great fit. Features like the cash surrender value and accumulation fund may potentially allow the client to make much larger contributions than, say, a tax-free savings account.”
How it works
There are two conditions that must be met:
- The insured must be a child of the policyholder or a child of the transferee, and
- The insurance contract must be transferred to a child of the policyholder, without any form of payment in return.
These rules have a very broad definition of child, and include, among other relationships, grandchildren and great grandchildren.
Take Maurice, father of Martin and grandfather of William. He has some extra money he wants to leave to his grandson.
Éric describes two different strategies for using life insurance:
- Insuring the life of William.
- Insuring the life of Martin and then transferring the policy to William at a later date.
“In both these cases, Maurice would contribute more than the minimum deposit or premium up to the exemption limit under tax legislation,” says Éric. “He builds up the cash surrender value or accumulation fund to increase the value of the contract on a tax-deferred basis.”
Maurice pays the premiums or makes deposits over five to 10 years. Depending on the accumulated amounts and their returns, this could keep the contract in force with no further payments required by Martin or William.
Option one: Maurice buys life insurance for his grandson William
As the premium payor and owner of the insurance contract, Maurice could assign ownership to William at age 18.
William could use the funds to finance his education or buy a house. Or he could keep the policy to guarantee his future insurability or obtain additional low-cost life insurance, depending on the features of the contract. Either way, Maurice has fulfilled his wish to help William with his future life goals.
When a withdrawal or a surrender are made, the taxable gain would be included in William’s income, since he’s now the owner. Because William’s income will likely be lower than Maurice’s, the amount would be taxed at a lower rate, which results in savings.
In case Maurice dies before William turns 18, Martin (William’s father) is appointed contingent owner. This way, the policy will automatically transfer to Martin upon Maurice’s death. If that should happen Martin will then be able to transfer the insurance contract to William without tax consequences, no matter when he decides to do so.
Option two: Maurice buys life insurance for his son Martin
In this case, Maurice would insure the life of his son Martin with the intent of transferring the funds to William.
When the life insured is young, insurance coverage amounts tend be lower, so using a minor’s life may result in less funding room within the policy than with an adult’s. This is why Maurice might decide to take out life insurance on Martin’s life instead, for William to ultimately benefit. In this case, Maurice would insure the life of his son Martin with the intent of transferring the funds to William.
Maurice would appoint Martin as contingent owner so ownership of the life insurance policy could be transferred tax free at his death. Martin could then continue making deposits or paying premiums, or use the cash surrender value or accumulation fund any way he wanted. For example, he could cash out the value of the contract to fund William’s education or help him buy his first house. There would be tax consequences to this though, and the taxable gain from the policy would be included in Martin’s income.
Or, Martin could retain ownership of the policy and designate William as beneficiary, meaning that after his father’s death William would receive the death benefit on a tax-free basis.
The benefits go beyond preserving estates
Intergenerational wealth transfers have other benefits.
Maurice would defer and/or reduce tax payable during his lifetime on the investment growth within the contract. Also, as owner of the policy, Maurice has access to the cash surrender value or accumulation fund until he transfers it.
Life insurance provides benefits that go well beyond income protection; it’s also a wealth transfer, savings and financial planning tool.
For more information about advanced planning at Sun Life Financial, contact your Sales Director.
1 Investor Economics, Household Balance Sheet Report, 2013